The poor performance by the bond market this year could turn around in 2019, says Kathy Jones, chief fixed income strategist at Charles Schwab.
“Inflation is still quite low,” as are long-term inflation expectations, says Jones who spoke at this week’s Schwab Impact conference in Washington.
Year to date, the iShares Core U.S. Aggregate Bond ETF, which provides exposure to investment-grade bonds including Treasuries, agencies and corporates, is down about 2% following a bull market in bonds that dates back to 1982, with only three down years in between (the last one was 2013).
“We’re still in a low rate environment that will keep rates subdued,” said Jones.
She says the 10-year Treasury yield, which has retreated from a recent high of 3.25%, is near its peak and the short-term federal funds rate will likely top out near 3%, following three more Fed rate hikes. (The current fed funds rates is set between a range of 2% and 2.25% and are expected to remain unchanged when Fed policymakers meet again next week.)
Given this outlook, Jones recommends that bond investors start to move out on the yield curve and take on more duration risk.
“The risk premia for bonds will return and recent losers could become winners,” says Jones.
She recommends investment-grade bonds with maturities between two and seven years. At seven years investors get about 90% of the yield all the way out the curve, according to Jones.
She also recommends that U.S. bond investors “move up in credit quality, especially in corporate bonds,” because investors “aren’t being compensated to take on much credit risk,” and that they “stay close to home,” buying U.S. dollar-denominated debt because the currency will stay strong.
Finally, Jones suggests that U.S. bond investors “play defense with diversification and liquidity” because liquidity is declining in U.S. and global markets as central banks retreat from accommodative easing policies.
“When liquidity goes out, volatility increases, risk spreads increase and there is a divergence in performance,” says Jones.
Schwab is neutral on investment grade and high yield bonds — investors are not compensated enough for risk if the economy starts to deteriorate, says Jones — and underweight emerging market bonds in large part because a strong dollar hurts many sovereign issuers whose debt is denominated in the greenback.
Jones likes preferred securities with “fat coupons” when their prices are cheap, but cautions that retail investors shouldn’t buy these securities on their own due to that market’s idiosyncratic behavior.
She’s also likes investment-grade floating rate debt whose payments reset when rates rise, preferring them to bank loans, which have more credit risk. “There’s still room to buy floaters so long as the Fed tightens,” says Jones.
Muni bonds are another bond asset Jones likes in the current market. Supplies have been held in check and demand is strong, especially among high-net-worth investors living in high-tax states, says Jones. Given the $10,000 cap on state and local tax deductions enacted in the big tax cut legislation, those investors are looking for other tax-advantaged investments.
— Check out Expect Fewer Recessions but Weaker Recoveries: J.P. Morgan on ThinkAdvisor.